Do Investors Have the ‘Luck of the Irish’?
People like to say everyone is Irish on St. Patrick’s Day. Does that include investors?
This time of year, the icons supposedly representing Irish culture are everywhere, from restaurants serving plates of corned beef and pints of Guinness to parade revelers donning the color green and novelty good-luck charms. Some are actually American creations such as the phrase “luck of the Irish.”
According to Edward T. O’Donnell, author of 1001 Things Everyone Should Know About Irish American History, the phrase originated in America in the 19th century as a derisive term toward Irish and Irish Americans that made fortunes during the gold and silver rushes. Their success was intolerantly attributed by others to dumb luck rather than skill or ingenuity.
There’s a similar misinterpretation between skill and luck in finance. Emotionally, people can be vulnerable to an overconfidence bias, especially after a string of good returns. This causes people to overestimate their intuition and abilities. Or, they may feel that luck is on their side. For average investors – and even more so for those that try to time the market or select securities – this bias may lead to decisions based on probabilities skewed by their believed skill or luck rather than the actual likelihood of a certain outcome.
Data show this exuberance is highly unwarranted. A well-circulated graph by BlackRock depicts the average investor’s lack of skill. Over a 20-year period, the average investor had annualized returns of 2.1%, underperforming asset classes such as stocks (7.8%) and bonds (6.6%), and even trailing inflation (2.6%).
It appears that overconfidence in an investor is as productive as “liquid courage” after one too many green beers.
Evidence supporting luck rather than skill among investors also extends to finance professionals such as active fund managers. While recently successful managers are galvanized by the media for supposed investment prowess along the lines of a professional athlete, the data indicates otherwise.
In a 2010 paper entitled, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” the Swiss Finance Institute found only 12 fund managers seemed to display skill in the market out of 2,076 actively managed U.S. equity mutual funds studied from 1975 to 2006.
It’s possible to beat the market for short periods, but over the long term outperformance is typically just a consequence of a long dance with lady luck.
However, investors are not solely at the mercy of good fortune. They are capable of increasing their probability of success by focusing on the things that are within their control: low investments costs, a properly diversified asset allocation, consistent rebalancing and risk management. That’s something we can all raise a pint to.